Too Much Debt Means the Economy Can’t Grow: Reinhart and Rogoff

July 14 (Bloomberg) -- As public debt in advanced countries
reaches levels not seen since the end of World War II, there is
considerable debate about the urgency of taming deficits with
the aim of stabilizing and ultimately reducing debt as a
percentage of gross domestic product.

Our empirical research on the history of financial crises
and the relationship between growth and public liabilities
supports the view that current debt trajectories are a risk to
long-term growth and stability, with many advanced economies
already reaching or exceeding the important marker of 90 percent
of GDP. Nevertheless, many prominent public intellectuals
continue to argue that debt phobia is wildly overblown.
Countries such as the U.S., Japan and the U.K. aren’t like
Greece, nor does the market treat them as such.

Indeed, there is a growing perception that today’s low
interest rates for the debt of advanced economies offer a
compelling reason to begin another round of massive fiscal
stimulus. If Asian nations are spinning off huge excess savings
partly as a byproduct of measures that effectively force low-income savers to put their money in bank accounts with low
government-imposed interest-rate ceilings -- why not take
advantage of the cheap money?

Although we agree that governments must exercise caution in
gradually reducing crisis-response spending, we think it would
be folly to take comfort in today’s low borrowing costs, much
less to interpret them as an “all clear” signal for a further
explosion of debt.

Changing Interest Rates

Several studies of financial crises show that interest
rates seldom indicate problems long in advance. In fact, we
should probably be particularly concerned today because a
growing share of advanced country debt is held by official
creditors whose current willingness to forego short-term returns
doesn’t guarantee there will be a captive audience for debt in
perpetuity.

Those who would point to low servicing costs should
remember that market interest rates can change like the weather.
Debt levels, by contrast, can’t be brought down quickly. Even
though politicians everywhere like to argue that their country
will expand its way out of debt, our historical research
suggests that growth alone is rarely enough to achieve that with
the debt levels we are experiencing today.

While we expect to see more than one member of the
Organization for Economic Cooperation and Development default or
restructure their debt before the European crisis is resolved,
that isn’t the greatest threat to most advanced economies. The
biggest risk is that debt will accumulate until the overhang
weighs on growth.

Historical Precedents

At what point does indebtedness become a problem? In our
study “Growth in a Time of Debt,” we found relatively little
association between public liabilities and growth for debt
levels of less than 90 percent of GDP. But burdens above 90
percent are associated with 1 percent lower median growth. Our
results are based on a data set of public debt covering 44
countries for up to 200 years. The annual data set incorporates
more than 3,700 observations spanning a wide range of political
and historical circumstances, legal structures and monetary
regimes.

We aren’t suggesting there is a bright red line at 90
percent; our results don’t imply that 89 percent is a safe debt
level, or that 91 percent is necessarily catastrophic. Anyone
familiar with doing empirical research understands that
vulnerability to crises and anemic growth seldom depends on a
single factor such as public debt. However, our study of crises
shows that public obligations are often hidden and significantly
larger than official figures suggest.

Creative Accounting Devices

In addition, off-balance sheet guarantees and other
creative accounting devices make it even harder to assess the
true nature of a country’s debt until a crisis forces everything
out into the open. (Just think of the giant U.S. mortgage
lenders Fannie Mae and Freddie Mac, whose debt was never
officially guaranteed before the 2008 meltdown.)

There also is the question of how broad a measure of public
debt to use. Our empirical work concentrates on central-government obligations because state and local data are so
limited across time and countries, and government guarantees, as
noted, are difficult to quantify over time. (Until we developed
our data set, no long-dated cross-country information on central
government debt existed.) But state and local debt are important
because they so frequently trigger federal government bailouts
in a crisis. Official figures for state debts don’t include
chronic late payments (arrears), which are substantial in
Illinois and California, for example.

Public and Private Debt

Indeed, it isn’t unusual for governments to absorb large
chunks of troubled private debt in a crisis. Taking this into
account, chart 1, attached, shows the extraordinarily high level
of overall U.S. debts, public and private.

In addition to ex-ante or ex-post government guarantees and
other forms of “hidden debts,” any discussion of public
liabilities should take into account the demographic challenges
across the industrialized world. Our 90 percent threshold is
largely based on earlier periods when old-age pensions and
health-care costs hadn’t grown to anything near the size they
are today. Surely this makes the burden of debt greater.

There is a growing sense that inflation is the endgame to
debt buildups. For emerging markets that has often been the case,
but for advanced economies, the historical correlation is weaker.
Part of the reason for this apparent paradox may be that,
especially after World War II, many governments enacted policies
that amounted to heavy financial repression, including interest-rate ceilings and non-market debt placement. Low statutory
interest rates allowed governments to reduce real debt burdens
through moderate inflation over a sustained period. Of course,
this time could be different, and we shouldn’t entirely dismiss
the possibility of elevated inflation as the antidote to debt.

Extremely Rare

Those who remain unconvinced that rising debt levels pose a
risk to growth should ask themselves why, historically, levels
of debt of more than 90 percent of GDP are relatively rare and
those exceeding 120 percent are extremely rare (see attached
chart 2 for U.S. public debt since 1790). Is it because
generations of politicians failed to realize that they could
have kept spending without risk? Or, more likely, is it because
at some point, even advanced economies hit a ceiling where the
pressure of rising borrowing costs forces policy makers to
increase tax rates and cut government spending, sometimes
precipitously, and sometimes in conjunction with inflation and
financial repression (which is also a tax)?

Even absent high interest rates, as Japan highlights, debt
overhangs are a hindrance to growth.

The relationship between growth, inflation and debt, no
doubt, merits further study; it is a question that cannot be
settled with mere rhetoric, no matter how superficially
convincing.

In the meantime, historical experience and early
examination of new data suggest the need to be cautious about
surrendering to “this-time-is-different” syndrome and
decreeing that surging government debt isn’t as significant a
problem in the present as it was in the past.

(Carmen M. Reinhart is a senior fellow at the Peterson
Institute for International Economics in Washington. Kenneth S.
Rogoff is a professor of economics at Harvard University. They
are co-authors of “This Time is Different: Eight Centuries of
Financial Folly.” The opinions expressed are their own.)